The Handy Accounting Answer Book

By Amber K. Gray

Nearly 800 answers to common questions on accounting fundamentals, concepts, and terms

Written by a professor of accounting, but aimed at general audiences with no or little prior accounting experience

Brings insight into the language of business

Helps readers understand how to run or manage personal or company finances

The first, best place to turn for an overview of accounting basics

Ideal as an authoritative reference for nagging questions

Ideal as a primer on accounting

Logical organization makes finding information quick and easy

Clear and concise answers

Numerous black-and-white photographs

Thoroughly indexed

Authoritative resource

Written to appeal to anyone interested in finances or business, including business people, students, and teachers

Publicity and promotion aimed at the wide array of websites devoted to business and personal finances

Promotion targeting business magazines and newspapers

Promotion targeting local radio looking for knowledgeable guests

• Language: English
• Publisher: Visible Ink Press
• Release date: Apr 1, 2019
• ISBN: 9781578596997

Book preview

Table of Contents

ACKNOWLEDGMENTS

PHOTO SOURCES

INTRODUCTION

WHAT IS ACCOUNTING?

Accounting Defined … Users of Accounting Information … Early Accounting … A Very Brief History of Financial Accounting in the United States

FASB’S CONCEPTUAL FRAMEWORK

The FASB … The Conceptual Framework … Qualitative Characteristics Elements of Financial Statements … Recognition, Measurement, and Disclosure Concepts

FINANCIAL STATEMENT ELEMENTS

Elements … Assets … Liabilities … Equity, Investments by Owners, and Distributions to Owners … Revenues and Expenses … Gains, Loses, and Comprehensive Income

FOUR BASIC FINANCIAL STATEMENTS

Financial Statements … The Basic Accounting Equation … The Income Statement … The Statement of Retained Earnings … The Balance Sheet … The Statement of Cash Flows … Other Financial Reporting

FINANCIAL STATEMENT ANALYSIS

Analysis Basics … Horizontal Analysis … Vertical Analysis … Ratio Analysis Basics … Liquidity Ratios … Solvency Ratios … Profitability Ratios … Asset Management Ratios … Market Performance Ratios … The Balanced Scorecard

BOOKKEEPING AND THE ACCOUNTING CYCLE

The Accounting Cycle … Steps 1–3: Analyze, Record, and Post … Steps 4–8: The Month-End Close … Steps 9–11: The Year-End Close … Source Documents in the Accounting System

SPECIFIC ACCOUNTING ISSUES

Fraud and Internal Controls … Merchandisers … Inventory Accounting … Accounts Receivable and Bad Debt … Fixed Assets and Intangibles … Payroll Accounting

COST ACCOUNTING BASICS

The Operating Cycle … Cost Classifications … Job-Order Costing … Activity-based Costing … Process Costing … Other Costing Systems

BUDGETING, PLANNING, AND CONTROLLING

Why Budget? … The Master Budget … Flexible Budgets … Standard Costs and Variances

MANAGERIAL ACCOUNTING BASICS

The Contribution Format Income Statement … Cost-Volume-Profit Analysis … Managerial Decision Making … Drop or Retain a Segment … Make or Buy … Special Order … Constrained Resources … Responsibility Accounting … Capital Budgeting

STARTING A SMALL BUSINESS

Choosing a Business Structure … Creating a Business Plan … Setting Up an Accounting Information System … Profit and Cash Flow … Employees and Payroll … Tax Issues

ACCOUNTANTS AND THE FUTURE OF ACCOUNTING

Accounting Careers … Credentials … Major Players … Notable Accountants … Accounting Scandals … The Future of Accounting

APPENDIX 1: JOURNAL ENTRIES

APPENDIX 2: PARTNERSHIP ACCOUNTING

APPENDIX 3: FINANCIAL STATEMENTS

APPENDIX 4: ANNUAL REPORT EXAMPLE

GLOSSARY

FURTHER READING

INDEX

Dedication

This book is dedicated to Patrick, Lucas, and Olivia, whose patience, love, and support made writing this book possible. You guys are the best!

Acknowledgments

There are many people whose support and assistance made this book possible. I would like to thank Marsha Fielder for making me aware of this opportunity, Roger Jänecke and Kevin Hile for their support and brainstorming efforts, Patrick Quinlan for encouraging me to write, Keith Christy for motivating me to keep writing, and the rest of my colleagues at Adrian College for cheering me on in the process. Additionally, I’d like to thank Jack Ruhl of Western Michigan University for giving me my first teaching opportunity, and Jerry Kreuze, David Rozelle, and Chip Hines for helping me to see how cool accounting can be.

Photo Sources

Florida Times: p. 288.

Louvre Museum: p. 5.

Mblumber (Wikipedia): p. 7.

Museo Nazionale di Capodimonte: p. 6.

Shutterstock: pp. 3, 14, 16, 18, 20, 22, 25, 28, 36, 78, 82, 90, 107, 262, 269, 272, 276, 280, 284, 286.

U.S. Government: p. 283.

All line art by Amber K. Gray and Kevin Hile. Shutterstock images used in graphics created by Kevin Hile on pp. 164, 166, and 192.

Introduction

The study of accounting is often dreaded by business students. They seem to look at accounting as an unfortunate hurdle in the process of getting their business degree. My goal is to change their minds. A person cannot truly understand business without first understanding accounting. Most people know that profit is good and losses are bad, but they do not actually know what profit is or what transactions cause profit to increase or decrease. Accounting is the language of business. It is my hope that in reading this book, you will start to understand that language to make sense of business decisions that have been made and to understand the ramifications of those decisions.

Every item that shows up on a financial statement starts with a transaction. Accountants must analyze those transactions and record them in the accounting system. The accounting system summarizes the data and results in the preparation of financial reports. Those reports are consulted by both internal and external users to make decisions. Just as a good cook needs to understand how different ingredients and flavors work together in a recipe, a good business person needs to understand how various transactions impact the financial reports of the business.

This book touches on many aspects of accounting that are found in introductory accounting textbooks, such as how to prepare financial statements, how to calculate financial ratios, and how to budget. In addition, this book includes information that would be helpful to non-accountants who want to understand business better or perhaps start a small business one day. For them, it explains such important issues as business plans and employee payroll issues.

Many of the examples in this book are very simplistic so as to clearly illustrate basic accounting concepts. I have attempted to use examples that are relatable to most people. Not all accounting concepts are covered in this book, nor should they be. My hope is that this book will allow you to understand the language of business to be able to make better decisions, whether as an employee, owner, investor, or individual. Most importantly, I hope you enjoy it and find that you learn a little bit of something new and interesting.

—Amber K. Gray

WHAT IS ACCOUNTING?

ACCOUNTING DEFINED

What is accounting?

Accounting is a system of record keeping designed to analyze, record, and summarize the activities of the business and report the results to users. The process of analyzing, recording, and summarizing these activities is discussed in detail in the chapter entitled Bookkeeping and the Accounting Cycle.

What are the main activities of the business?

A business’s activities can be divided into three main categories: operating, investing, and financing. Operating activities are those activities that involve running the business. For example, the operating activities of a Jimmy John’s Sandwiches franchise would include buying ingredients and paying wages to employees. Investing activities are those activities that involve making an investment in your business or other business through the purchase of stock. For example, the investing activities of a Jimmy John’s Sandwiches franchise could include buying the building for the restaurant and buying the furniture that goes in it. Financing activities are those activities that involve getting the funds necessary to cover the operating and investing activities of the business. A business can be financed with debt and/or equity. Debt involves borrowing money that must be paid back. Equity involves receiving investments from owners. For example, the financing activities for a Jimmy John’s Sandwiches franchise could include any loans taken from the bank to finance the purchase of the building and any money contributed by the owners upon the start-up of the franchise. All of these activities must be recorded by the accounting system.

Why is accounting referred to as the language of business?

In order to understand and manage a business, you must understand the nature and the impacts of the operating, investing, and financing decisions. You must understand how transactions occur, how they are recorded, and where they show up in the financial reports. Accounting takes multitudes of data (daily transactions) and turns it into useful information (in the form of financial reports). Just like you would want at least some basic knowledge of the French language prior to taking a trip to France, everyone wishing to understand the activities of the business should have at least some basic knowledge of accounting. If you don’t understand accounting, it will be hard to understand business.

Will reading this book make you an expert in accounting?

No. Reading this book will not make you an expert in accounting. What this book will do is give you some basic knowledge of both financial and managerial accounting so that you can better understand the business world and make more informed decisions. Think of it like taking a French/English dictionary with you on your trip to France. You won’t be able to speak the language fluently, but you’ll understand enough to have an enjoyable trip.

USERS OF ACCOUNTING INFORMATION

Who uses accounting information?

There are two basic types of users of financial information: external and internal. External users are those users who are outside the company. External users typically include creditors (people who loan the business money) and investors (stockholders). External users can also include other stakeholders, such as the government, customers, suppliers, etc. Internal users are those users who are inside the company. Internal users include executives, managers, supervisors, etc.

What type of financial information are external users most interested in?

External users are typically interested in evaluating the financial condition of the business to determine whether or not they will get a return on their investment or be paid back for any loans.

How is the accounting information reported to external users?

Information about the financial condition of the company is reported by the accounting system in the form of reports called financial statements. These reports provide information about the financial position, profitability, and cash flows of the business. Financial statements are covered in detail in the chapter entitled Four Basic Financial Statements.

What type of financial information are internal users most interested in?

Internal users are typically interested in understanding the financial condition of the business so that they can make decisions to run the company. Decisions may range from day-to-day activities to the overall long-range strategy of the company.

How is the accounting information reported to internal users?

While internal users also rely on information provided in the financial statements, there are a large variety of other reports and information that are used by internal users. Examples of these reports include budgets, profitability by customer and by product analyses, and employee payroll data.

What is the difference between financial accounting and managerial accounting?

Financial accounting is directed toward preparing information for external users to evaluate the company. Financial accounting reports details about transactions that occurred in the past. Financial accounting places emphasis on precision and must follow the rules of accounting, called generally accepted accounting principles. Financial accounting is discussed in detail in the chapters entitled FASB’s Conceptual Framework, Financial Statement Elements, Four Basic Financial Statements, Bookkeeping and the Accounting Cycle, and Specific Accounting Issues."

Internal users gain information about their business through financial statements provided by accountants. Various types of reports have to be reviewed to gain a complete picture of a company’s financial health.

Conversely, managerial accounting is directed toward preparing information for internal users to use in running the business. Managerial accounting reports often emphasize a focus on decisions that will impact the future. Managerial accounting places an emphasis on having the data quickly in order to make decisions, and as such, many estimates are used. There are no prescribed formats for managerial accounting reports, and there are no rules that must be followed for managerial accounting. Managerial accountants work in the interest of the business and create whatever reporting formats they need to effectively run the business and make decisions. Managerial accounting is discussed in detail in the chapters entitled Cost Accounting Basics, Budgeting, Planning, and Controlling, and Managerial Accounting Basics.

How are private accountants different from public accountants?

Private accountants are accountants who are employees of the business. Private accountants can be either financial or managerial accountants. As such, private accountants may focus their efforts on preparing financial information for external users or they may focus their efforts on preparing information for internal users. Public accountants are those accountants who work for an accounting firm and provide advice or perform tasks on behalf of their clients. Public accountants often provide tax advice, prepare tax returns, compile financial statements, or audit the financial statements of the business. Many businesses utilize both private and public accountants. For example, a Jimmy John’s Sandwiches franchise may hire an employee as a bookkeeper to keep the day-to-day records of the business and also hire an accounting firm to compile quarterly financial statements and prepare tax returns.

How are accounting and finance different?

Finance is often described as the bridge between accounting and economics. Economics provides information about the environment in which businesses operate. Accounting provides detailed information about the results of the business. The field of finance utilizes accounting data and economic concepts to help make decisions affecting the financial results of the business. Finance and accounting roles and business functions often overlap. As such, it is a good idea for finance personnel to have a strong knowledge of accounting and for accounting personnel to have a strong knowledge of finance.

EARLY ACCOUNTING

What is the earliest known form of accounting?

The earliest known forms of accounting involved keeping track of inventory. Archaeologists have found accounting systems in Mesopotamia dating back to as early as 7000 B.C.E. These early accounting systems involved the utilization of clay tokens to keep track of items that were owned or exchanged. Different shapes of clay tokens related to different items. For example, a cylinder represented an animal. French archaeologist Denise Schmandt-Besserat first discovered that the token system was an early accounting system.

Did accountants really invent writing?

As discussed in the book Double Entry by Jane Gleeson-White, it does appear that accountants invented writing. The token system discussed above evolved through the ages. By 3500 B.C.E., there were more than three hundred token shapes used to record inventory. These tokens were stored in hollow, clay balls. Around 3300 B.C.E., the system evolved so that tokens were no longer stored in hollow, clay balls, but rather, the wet clay was flattened out, and the tokens were used to press an imprint of their shape onto the wet clay. This was essentially the creation of the world’s first clay tablets. Eventually, this system evolved further. Rather than pressing the tokens onto the wet clay to record their shape, a stylus was used to draw the shape onto wet clay. Thus, as noted by Gleeson-White, writing was invented.

The ancient Mesopotamians used clay tokens like these (c. 3500 B.C.E.) on display at the Louvre Museum to keep track of items. Behind the tokens is a Bulla, a hollowed-out clay (or soft metal) envelope with a seal to contain smaller items such as these tokens.

When was modern accounting invented?

Our modern form of accounting, known as the double-entry system, dates back to around 1300.

Who invented modern accounting?

It is believed that modern accounting was first invented in Tuscany, Italy, by merchants. The earliest known records of double-entry accounting are from the Florentine merchants Rinieri Fini & Brothers and Giovanni Farolfi & Co., dating back to around 1300. By the 1430s, double-entry accounting had been perfected by the merchants of Venice.

Who is the father of modern accounting?

While not the inventor of modern accounting, Luca Bartolomeo de Pacioli is known as the father of accounting. He was an Italian mathematician, monk, and friend of Leonardo da Vinci. Pacioli was the first to codify and print the particulars of the double-entry accounting system that is still in use today. Pacioli’s publication on double-entry bookkeeping, entitled Particularis de computis et scripturis, was published in his mathematical encyclopedia in 1494. The title is translated to mean Particulars of Reckonings and Writings.

Franciscan friar and mathematician Luca Pacioli (at left) is considered to be the Father of Accounting and Bookkeeping. He wrote the first book on double-entry bookkeeping (i.e., keeping track of both debits and credits by making entries in both the receiving and paying accounts).

A VERY BRIEF HISTORY OF FINANCIAL ACCOUNTING IN THE UNITED STATES

How did the double-entry accounting system arrive in the United States?

The double-entry accounting system arrived in the United States with the European settlers. This was a trade passed down from master to apprentice.

When was the first American text on double-entry accounting written?

The first American double-entry accounting text was most likely the work of Thomas Sarjeant, entitled An Introduction to the Counting House, which was written in 1789.

How did the railroad industry impact accounting in the United States?

The boom of the railroad industry in the mid-1800s led to major advancements in accounting. Prior to the railroads, much of accounting was merely a function of bookkeeping. However, railroads were expensive and required a great deal of funds from investors. Additionally, the significant amount of assets required by the railroads led to a greater focus on accounting for depreciation. As these investors required greater details regarding their investments, accounting evolved to meet those needs. This helped lead to the emergence of published financial reports and the arrival in the 1880s of British chartered accountants to audit financial reports.

What was the first recognized professional accounting organization in the United States?

The first professional accounting organization recognized in the United States was the Institute of Accounts of New York, which was created in 1882 and had a focus on education of accountants and providing accounting literature. Similar organizations in other cities soon followed. The American Association of Public Accountants was formed in 1887 and has evolved into what is now the American Institute of Certified Public Accountants.

Deloitte Touche Tohmatsu Ltd. in Chicago is the modern version of Haskins & Sells, which was founded in America in 1895. It later merged with other auditing firms to become Deloitte.

Who formed the first major American auditing firm?

Two accountants, Charles Waldo Haskins and Elijah Watt Sells, both worked as bookkeepers in the railroad industry and eventually for the government. They later got together and formed the first major auditing firm formed by Americans, Haskins & Sells, in 1895.

When was accounting first recognized as a profession in the United States?

The profession of accounting was first recognized in the United States in 1896 by the passing of a law in New York. The title of certified public accountant (CPA) was only given to people who had passed state examinations and had three years of experience in the field.

When did accounting practices in the United States become more standardized?

The stock market crash of 1929 led users of financial information to question the reliability of financial reports. Accordingly, Congress passed the Securities Acts of 1933 and 1934 to boost investor confidence. The Securities and Exchange Commission (SEC) was created by the 1934 Securities Act whereby Congress gave the SEC the authority to set accounting standards (rules) for publicly traded companies.

Does the SEC still have authority to set accounting standards?

Yes, it does, but it delegates that task to the private sector. Additionally, as a result of the large accounting frauds uncovered in the 1990s, Congress passed the Sarbanes–Oxley Act in 2002, which created the Public Company Accounting Oversight Board (PCAOB) to develop standards for the audits of public companies. The standards developed by the PCAOB are subject to the approval of the SEC.

What was the first private sector organization to set accounting rules under the authority of the SEC?

The first organization that was delegated the task of setting accounting standards was the Committee on Accounting Procedure (CAP). The CAP set accounting standards from 1938 to 1959. The CAP never created a theoretical framework for accounting but rather just issued rules addressing specific accounting issues. It was therefore criticized by the profession and later replaced.

What organization replaced the Committee on Accounting Procedure?

The second organization that was delegated the task of setting accounting standards was the Accounting Principles Board (APB), which was in operation from 1959 to 1973. Like the CAP, the APB was criticized for numerous reasons, including lack of creation of a conceptual framework, lack of efficiency, and lack of independence from the audit firms with which its members had relationships.

What organization replaced the Accounting Principles Board?

The third organization to be delegated the task of setting accounting standards was the Financial Accounting Standards Board (FASB), which was created in 1973. The FASB is still in place today as the standard setter for U.S. accounting. The FASB is discussed in more detail in the chapter entitled FASB’s Conceptual Framework.

How are the accounting standards organized?

As there are thousands of U.S. generally accepted accounting principle (GAAP) pronouncements (standards), the FASB implemented the Accounting Standards Codification in 2009 to help organize the multitude of pronouncements into approximately 90 topics, displayed using a consistent structure. The Codification can be accessed at www.fasb.org.

How did the development of modern technology impact the field of accounting?

Throughout the 1970s and 1980s, the inventions and utilization of personal computers, fax machines, and cell phones impacted the accounting profession in the ability to compute and share knowledge more efficiently and created the need for new accounting skills. The 1983 introduction of the spreadsheet software Lotus 1-2-3 was a first step into database accounting. Additionally, EDGAR, the electronic financial reporting filing system used by the SEC, was developed in the 1990s.

What other fields of accounting emerged in the United States?

Aside from financial accounting, the passage of the U.S. income tax law in 1913 created a demand for tax accounting practices. Additionally, cost accounting in the United States developed in the early 1800s (prior to financial accounting), as textile manufacturers used cost accounting techniques to estimate the labor and overhead costs required to turn materials into finished fabric.

FASB’S CONCEPTUAL FRAMEWORK

THE FASB

What is the FASB?

The FASB (pronounced FAZ-bee) is the Financial Accounting Standards Board. The FASB is an independent, not-for-profit organization that establishes financial accounting and reporting standards for public companies, private companies, and not-for-profit organizations that follow generally accepted accounting principles (GAAP). The mission of the FASB is to establish and improve financial accounting and reporting standards to provide useful information to investors and other users of financial reports and educate stakeholders on how to most effectively understand and implement those standards.

What is GAAP?

GAAP (pronounced gap) stands for generally accepted accounting principles. Put simply, generally accepted accounting principles are the rules that accountants must follow when recording and presenting accounting information. The FASB is responsible for setting those rules.

What authority does the FASB have?

The Securities and Exchange Commission (SEC) has designated the FASB as the accounting standard setter for public companies. Additionally, the American Institute of CPAs (AICPA) and state Boards of Accountancy also recognize the FASB as the authoritative standard setter for accounting in the United States.

When was the FASB created?

The FASB was established in 1973.

How many members are on the board of the FASB?

There are seven members on the board of the FASB who serve full-time and are required to cut all ties to the firms or institutions they worked for before serving on the board of the FASB. Board members are appointed for five-year terms and may serve up to ten years. FASB members are appointed by the Financial Accounting Foundation (FAF), which is the organization that is responsible for supporting and overseeing the FASB.

THE CONCEPTUAL FRAMEWORK

What is the conceptual framework?

The conceptual framework is the foundation that all accounting rules (GAAP) are based upon. The conceptual framework is to accounting what the U.S. Constitution is to the United States. The conceptual framework lays the groundwork for the rules of accounting much as the Constitution lays the framework for the laws of our country.

According to the FASB, The Conceptual Framework is a coherent system of interrelated objectives and fundamental concepts that prescribes the nature, function, and limits of financial accounting and reporting and that is expected to lead to consistent guidance. It is intended to serve the public interest by providing structure and direction to financial accounting and reporting to facilitate the provision of unbiased financial and related information. That information helps capital and other markets to function efficiently in allocating scarce resources in the economy and society.

What are the Concepts Statements?

The conceptual framework is made up of several Concepts Statements issued by the FASB. Per the FASB, Concepts Statements are intended to set forth objectives and fundamental concepts that will be the basis for development of financial accounting and reporting guidance. Concepts Statements Nos. 1, 2, and 3 have been superseded. Concepts Statement No. 4 relates to nonbusiness organizations. Concepts Statements Nos. 5, 6, 7, and 8 provide the key concepts for external financial reporting. These statements address the objective of financial reporting; the qualitative characteristics of financial reporting; the elements of financial reporting; recognition, measurement, and disclosure concepts; and the constraints of financial reporting, all of which are discussed in this chapter.

What is the objective of financial reporting?

The objective of financial reporting is to provide financial information that is useful to external users. External users are people outside the entity: namely, investors and creditors. Investors include both existing investors and potential investors. Creditors include both lenders and suppliers to the company.

QUALITATIVE CHARACTERISTICS

What are the qualitative characteristics of useful financial information?

The two fundamental characteristics of useful information according to the FASB are relevance and faithful representation. In addition to relevance and faithful representation, the FASB has also identified four enhancing characteristics of useful information: comparability, verifiability, timeliness, and understandability. These characteristics make information useful to external users.

What is relevance in the context of financial reporting?

In order for financial information to be relevant, it must make a difference in the decision process of the user. According to the FASB, information is relevant if it has predictive value and/or confirmatory value. If information has predictive value, that means it is useful to the user in predicting what future results might be. For example, looking at the net income from this year may help the user predict what next year’s net income might be. Likewise, information has confirmatory value if it helps the user confirm or change prior assumptions about financial information. For example, if it is predicted that a company’s net income will continue to increase over the next five years, the user can look at the net income each year to help confirm or change that prediction. In addition to predictive value and confirmatory value, materiality also impacts the usefulness of financial information.

What is materiality?

Financial information is considered material if its omission or misstatement would be significant enough to impact a user’s decision. Materiality can be both quantitative and qualitative. For example, if McDonald’s were to make a $10 revenue error on its financial statements, that would be considered quantitatively immaterial as compared to the total revenue of approximately $24.6 billion for 2016. As a matter of fact, the McDonald’s Corp. financial statements are rounded to millions. So, really, errors or omissions between $1 and $49,000 wouldn’t necessarily even change the appearance of the financial statements due to rounding. Essentially, a user wouldn’t even notice the $10 if it were there, and as such, its omission or misstatement would not change the user’s decision, and it would be quantitatively immaterial. However, if that $10 misstatement was enough to take McDonald’s from having a net loss (negative) of $8 to a net income (positive) of $2, that would be considered qualitatively material, as it changes the overall financial information from a loss situation to a profit situation. Fortunately, for McDonald’s, its 2016 net income was approximately $4.7 billion, so a potential $10 error in sales revenue would be both quantitatively and qualitatively immaterial, meaning that it wouldn’t make a difference to the user whether it was there or not.

What is faithful representation?

Faithful representation means that the user can rely on the information as being presented truthfully. The technical definition of faithful representation means that there is agreement between a measure or description and the object that the measure is supposed to represent. For example, if a financial statement says cash, the user will understand that this represents currency on hand and in checking and savings accounts, not a pile of beans kept in a drawer somewhere. The FASB breaks faithful representation down further into three components: completeness, neutrality, and freedom from errors.

A successful company such as McDonald’s has yearly earnings in the billions. Because of this, if there is an accounting error in the thousands, it will go pretty much unnoticed in financial statements because of rounding numbers to the millions. Therefore, such mistakes go unnoticed by shareholders.

Information is considered to be complete if it includes all the information necessary for faithful representation. This is similar in nature to materiality in that omitting a portion of information (being incomplete) can cause the information to be misleading and thus not represented faithfully.

Information is considered to be neutral if it is free from bias. The FASB is tasked with setting accounting rules that result in financial information that is free from bias and thus represents the true nature of each transaction. This can be a difficult challenge when political pressures arise, and interest groups argue for accounting rules that may be more advantageous to their institutions.

Finally, faithful representation is enhanced when information is free from error. While this sounds quite obvious, there are actually many estimates made in accounting and financial information. Those estimates can result in inaccuracies or errors in financial information. For example, accountants are required to estimate the amount of money that customers owe them that may eventually be uncollected (called bad debts). There is no way to know that information for sure, so accountants must rely on estimates and use their best judgment. Accordingly, estimates are considered to be faithfully represented when the user is made aware of the fact that the amount contains an estimate.

Why is conservatism not included in the conceptual framework?

Conservatism in the accounting sense generally refers to the idea that when in doubt, an accountant should err on the side of underestimating good news and overestimating bad news. However, this sentiment is rejected by the FASB in Concepts Statement No. 8, as conservatism is in direct contrast with neutrality, as described above. Conservatism adds bias, which is in opposition to being neutral. Regardless of the FASB’s rejection of conservatism, many accountants employ conservatism in their estimates under the thought that users of financial information are typically less unhappy when results turn out better than expected versus when results turn out worse than expected, as common sense would tell you.

What is comparability?

Comparability enhances the usefulness of financial information by making financial information comparable across different companies and over time. For example, the financial statements of McDonald’s Corp. can be compared to the financial statements of Wendy’s Co. This comparison enhances the usefulness of the financial information contained in both companies’ financial statements. For instance, McDonald’s had total sales revenue in 2016 of approximately $24.6 billion, as compared to Wendy’s total sales revenue of approximately $1.4 billion for the same period. Because users know that Mc-Donald’s and Wendy’s are recording sales revenue according to the same rules, those two figures can be compared to each other to determine which company has more sales, etc.

Additionally, comparability means that you can compare information over time. For example, when looking at Wendy’s Co. financial statements, you can see that sales revenues for 2014 were approximately $2 billion, sales revenues for 2015 were approximately $1.9 billion, and sales revenues for 2016 were approximately $1.4 billion. Knowing that Wendy’s has followed the same rules for accounting for sales each year means that the user can determine that there was a downward trend in sales revenue for Wendy’s over the three-year period noted. Likewise, when looking at McDonald’s Corp. financial statements, you can see that sales revenues for 2014 were approximately $27.4 billion, sales revenues for 2015 were approximately $25.4 billion, and sales revenues for 2016 were approximately $24.6 billion. Users can note a similar downward trend over the three-year period. This information can be very useful to investors or creditors deciding to invest in the company or extend credit to the company.

It should be noted that accounting rules sometimes give the accountants a choice between several alternatives in how to record certain transactions. Accountants are required to disclose those choices to the users so that users are informed as they compare across companies and across time periods, as this would affect the comparability and consistency of the financial information.

What is verifiability?

Verifiability means that the financial information should be able to be independently verified, or audited. For example, if an entity says it has $1 million cash, an auditor should be able to verify that by obtaining a statement from the bank and performing a reconciliation. Obviously, verifiability enhances the usefulness of financial information, as users would be able to have more confidence in the reported information.

Comparability works well when comparing two similar companies. For example, if you are analyzing the profitability of the fast food chain Wendy’s, a good comparison company would be McDonald’s or, perhaps, Burger King.

What is timeliness?

Timeliness means that users have the financial information in enough time to use it in their decision-making process. Information that is not timely is not useful. For example, if a company were to issue 2016 financial statements in the year 2020, that would be very untimely and quite useless for making decisions about 2017. In order to make decisions about 2017 and beyond, users would require 2016 information as soon as reasonably possible after the end of the 2016 year. Accordingly, to enhance the usefulness of information, the SEC requires publicly traded companies to report financial information every quarter and every year, and it sets deadlines for when this information must be published.

What is understandability?

Information is considered to be understandable when a reasonably informed user can comprehend it. If a user cannot understand the information, then the information is not useful. Note that this definition of understandable includes the words reasonably informed user. As such, financial information may not be comprehensible to an elementary school student but should be comprehensible to a user with a reasonable understanding of business and economics.

What is the key constraint of financial reporting?

The overarching constraint of financial reporting is that the benefits of the information outweigh the costs of providing that information. This is known as the cost effectiveness constraint. The costs of providing the information are the burden of the preparer and involve collecting, processing, and distributing the financial information. The benefits of the financial information are in providing external users with better decision-making ability. When the FASB makes rules, it attempts to determine the cost effectiveness of the new rule. For example, a rule that enhances financial transparency in such a way that it only provides a slight benefit to the external users but will cost companies considerable time, money, and effort to implement would not meet the cost effectiveness constraint and would most likely not be implemented.

ELEMENTS OF FINANCIAL STATEMENTS

What are the elements of financial statements?

The FASB identifies ten elements of the financial statements. These elements are the building blocks that accountants can use to construct the financial statements. The ten elements are: assets, liabilities, equity, investments by owners, distributions to owners, revenues, expenses, gains, losses, and comprehensive income. The ten elements are discussed in detail in the chapter entitled Financial Statement Elements.

What are the underlying assumptions of financial information?

There are four underlying assumptions of financial information that are not explicitly stated in the Concepts Statements. As these are assumptions, a reader can assume these four things when looking at financial information. The assumptions are: the separate entity assumption, the going-concern assumption, the time period assumption, and the monetary unit assumption.

What is the separate entity assumption?

The separate entity assumption is the assumption that the activities of the business are separate from the activities of the owner. Put another way, the activities recorded in the financial reports of a business reflect only the activities of that business. For example, the owner of a car wash business should not include his or her personal residence as part of the assets of the business.

What is the going-concern assumption?

The going-concern assumption is the assumption that the business will continue to operate into the foreseeable future. If a business does not believe that it will be able to meet its financial obligations through the next twelve months, it must disclose that information to users. Some common factors that could signal a decline in a company’s ability to continue as a going concern are loss of a key customer, negative operating cash flows, and declining sales, among many others.

What is the time period assumption?

The time period assumption is the assumption that the long life of a business can be divided up and measured in shorter periods, such as a month, a quarter, or a year. It is common for small businesses to report results on a quarterly and annual basis and for larger companies to report results on a monthly, quarterly, and annual basis.

What is the monetary unit assumption?

The monetary unit assumption is the assumption that the activities of the business should be reported according to a common unit of measure, which is the U.S. dollar in the United States. For example, U.S. companies that do business internationally translate their foreign currency into U.S. dollars prior to issuing financial statements.

The common unit of measure in the United States is, of course, the U.S. dollar. Companies outside the United States convert their currency to dollars when issuing statements to American companies.

RECOGNITION, MEASUREMENT, AND DISCLOSURE CONCEPTS

What are the recognition, measurement, and disclosure concepts?

The recognition, measurement, and disclosure concepts tell accountants when to record a transaction, how much to record, and what additional details should be revealed to the users of financial statements regarding that transaction. Recognition deals with when, measurement deals with how much, and disclosure deals with additional details. Each concept is discussed below.

What are the general recognition criteria?

Recognition deals with knowing when to record a transaction. In general, four criteria must be met in order to record a transaction in the accounting records. First, an item must meet the definition of a financial statement element, as discussed in the chapter entitled Financial Statement Elements. Second, it must be measurable with sufficient reliability. Third, the information about the item must be relevant, in that it is capable of making a difference in a user’s decision. Fourth, it must be reliable, in that the information is representationally faithful, verifiable, and neutral. In addition to these four criteria, recognition of any item in the financial statements is subject to the cost effectiveness constraint and the materiality threshold, as discussed earlier in this chapter.

Are all items subject to the same recognition criteria?

No. In addition to the four general criteria noted above, there are specific revenue and expense recognition rules that must be followed.

When is revenue recognized?

Revenue should be recognized (recorded in the financial statements) when goods or services are transferred to customers for the amount the company expects to be entitled to receive in exchange for those goods or services. Revenue may be recorded at a specific point in time or over time. For example, Pizza Hut recognizes revenue at a point in time when it sells a pizza. However, a landlord that rents a restaurant building to Pizza Hut recognizes revenue over time (each month) while Pizza Hut is its tenant.

It is important to note that revenue can be recognized before payment is received, at the same time payment is received, or after payment is received. Revenue is recognized when it is earned, not necessarily when